Hungary
First Post-Program Monitoring Discussions
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International Monetary Fund
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Publication Date:
15 Jun 2011
eISBN:
9781455279555
Language:
English
Keywords:
ISCR; CR; discussion; demand data; demand; estimate; real GDP; potential GDP; current account; real interest rate; foreign currency; monetary policy
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The economic development of Hungary after the economic crisis is discussed. Hungary’s economic program supported by Stand-By Arrangement has been successful in strengthening the economy and stabilizing market conditions. Given Hungary’s high public debt and large financing needs, Executive Directors emphasized the need for full and timely implementation of consolidation measures. Directors also recognized the positive collaboration between the European Union and the IMF during the program period. Furthermore, the foreclosure moratorium continues to prevent banks from cleaning balance sheets.

Abstract

The economic development of Hungary after the economic crisis is discussed. Hungary’s economic program supported by Stand-By Arrangement has been successful in strengthening the economy and stabilizing market conditions. Given Hungary’s high public debt and large financing needs, Executive Directors emphasized the need for full and timely implementation of consolidation measures. Directors also recognized the positive collaboration between the European Union and the IMF during the program period. Furthermore, the foreclosure moratorium continues to prevent banks from cleaning balance sheets.

I. Context

1. In recent months, the authorities have announced changes in their policy stance. The new policy mix, which has yet to be implemented, introduces structural fiscal adjustment to reduce high public debt as well as progress in addressing ongoing stress in banks’ real estate portfolios. The recent announcements contrast with the authorities’ approach only a few months ago, when they emphasized that rapid tax cut-induced growth, rather than policy adjustment, would be adequate to address outstanding vulnerabilities—a strategy that at the time raised concerns at the Fund (in the 2010 Article IV consultation)1 and the European Commission (EC) as well as in financial markets.

2. The Post-Program Monitoring (PPM) discussions focused on the new policy stance and how it would contribute to Hungary’s capacity to meet obligations to the Fund falling due in 2012–13. The next six to twelve months are a critical period in this respect, as in the next three years, Hungary faces both a difficult external amortization schedule and parliamentary elections. With the ruling Fidesz party continuing to command a substantial legislative majority, the capacity to implement reforms is adequate but political will remains uncertain. In this context, the authorities face a short window of opportunity to implement key reforms which strengthen Hungary’s fiscal and external position.

II. Setting

A. Recent Economic and Financial Developments

3. The recovery in the Hungarian economy remains weak due to a lack of domestic demand. After falling 14 percent in real terms in the 12 months to mid-2009, domestic demand has remained essentially flat. Still high unemployment, muted wage growth, falling consumer confidence, and stagnant credit are weighing on consumption. Meanwhile, fixed investment continues to decline amid considerable idle capacity, bottlenecks to credit supply, limited final demand, and an uncertain business environment. Recent data underscore concerns about the recovery: retail sales growth remains flat in early 2011 while the rate of decline in fixed investment actually accelerated in Q4 2010. Such weak demand has kept a lid on underlying inflationary pressures, while private real sector wage growth remained at historic lows. (See Figure 1)

Figure 1.
Figure 1.

Hungary: Recent Economic Developments, 2005-11

Citation: IMF Staff Country Reports 2011, 137; 10.5089/9781455279555.002.A001

Source: Haver.

4. Meeting budgetary targets remains a challenge. The 2010 general government deficit of 4.3 percent of GDP (ESA terms) exceeded its target by ½ percentage point—mainly at the local government level—despite a series of ad hoc corrective measures late in the year. This slippage implied a primary structural weakening of 1¾ percent of GDP in 2010, undoing much of the adjustment achieved during the 2008–10 Stand-By Arrangement (see the forthcoming Ex-Post Evaluation report). Poor budget performance continued into the start of 2011 where the first quarter central government cash deficit has already exceeded the government’s initial annual target, largely because revenues fell short of optimistic expectations.

5. The one bright spot has been the external sector, which continues to drive economic growth. The current account improved from a 7.3 percent of GDP deficit in 2008 to a 2.1 percent of GDP surplus in 2010. Though part of the adjustment is due to the impact of the slump in domestic demand on imports, exports remain the key driver of adjustment, rising 14 percent in 2010 amid strong demand from Germany.2 Exports strengthened further in early 2011 with February posting the largest trade surplus on record. Meanwhile, after the sharp outflows during the crisis, the capital and financial accounts have begun to normalize with rising portfolio investment compensating for continued deleveraging by parent banks. There has, however, also been a marked increase in negative errors and omissions to more than 2 percent of GDP in 2010, in line with similar developments elsewhere in the region.3 Gross international reserves are increasing, largely due to a pick-up in EU transfers and, more recently, successful sovereign debt placements of some €4 billion, which are deposited at the central bank (MNB).

6. While the banking system has been resilient, a key short-term risk to credit quality remains the strength of the Swiss franc (CHF). After-tax profit dropped from 9¼ percent in 2009 (return on equity) to 1¼ percent in 2010 on a consolidated basis, with the decline largely reflecting the introduction of the bank levy as well as further provisioning. Capital adequacy for the banking system as a whole improved marginally to 14.1 percent while non-performing loans again increased, reaching 9.1 percent, but at a slower pace than in previous periods. A key issue is that two-thirds of existing household loans are denominated in CHF which remains some 20–30 percent stronger against the forint than long-term averages. As a result, there are continuing concerns about households’ repayment and spending capacity as well as implications for banks’ balance sheets.

7. Household and corporate lending remain subdued, further limiting banks’ earnings. A mix of demand and supply factors continue to undermine credit growth including the weak economy, an uncertain business environment, and the ongoing ban on foreclosures. Amid such a weak environment for credit growth and earnings more broadly, banks have moved to further limit funding costs by selling forint assets (MNB bills), converting this liquidity into Foreign Exchange (FX) in the largely short term FX swap market, and repaying more expensive long-term foreign loans, both from parents and the wholesale market. As a result, the share of banks’ on- and off-balance sheet foreign funding that is short term has risen.

8. Despite the uncertain economic outlook, Hungarian asset prices have improved. Since early 2011, risk spreads have tightened roughly 150bps in absolute terms (see Text Figure 1) as the anticipation of fiscal reforms coincided with a general increase in portfolio investors’ appetite for assets in the region. CDS spreads have also dropped almost 100bps relative to new member state peers, but remain well above those posted before the change in government in April 2010. This persistent relative risk premium suggests lingering market concern about how the authorities will address outstanding vulnerabilities regarding public and external debt, official reserve coverage, and currency mismatches. In currency markets, the forint has strengthened since the mid-2010 sell-off. Nevertheless, CGER estimates still view the currency as broadly in line with fundamentals; in fact, when measured using unit labor costs, the real effective exchange rate is roughly 20 percent more competitive than before the crisis.

uA01fig01
Source: Bloomberg.

Hungary’s Crisis Vulnerabilities—Then and Now

Hungary’s economy is known for two key underlying vulnerabilities:

  • First, Hungary has high external debt of 140 percent of GDP, largely held by banks and the government. Banks’ foreign debt, at 36 percent of GDP, includes substantial borrowing from parents (two thirds of total). Meanwhile, the public sector has external debt of 53 percent of GDP, of which about 20 percent is non-residents holdings of local currency debt.

  • Second, both households and banks have substantial currency mismatches. Household balance sheets are short foreign currency as they have borrowed heavily in Swiss francs to finance mortgages and consumption. By contrast, banks hold more FX assets than they generate in FX funding and are thus long foreign currency. While households have limited ability to hedge this exposure, banks cover almost 90 percent of their open position with off balance sheet FX swaps and other instruments.

Both vulnerabilities played key roles in the crisis:

  • In late 2008, non-residents started a sharp sell-off in the local government bond market, which in turn triggered a large depreciation in the currency.

  • Furthermore, the fall in foreigners’ demand for Hungary exposure caused domestic banks without a parent to lose access to needed wholesale funding.

  • Meanwhile, the forint weakness created strains in the FX swap market: suddenly, banks faced difficulty in rolling over their swaps and faced margin calls on their remaining swaps.

  • As a result, the banking system as a whole faced dramatic pressure on liquid assets though banks with a parent were able to stabilize their liquidity by increasing borrowing abroad.

Two and a half-years later, Hungary is better placed to withstand similar shocks, including possible spillovers from problems in the European banking system. The MNB now has well-tested policy instruments to react to funding strains such as the FX swap facility. Furthermore, buffers are now much larger (see panel on subsequent page):

  • Banks have vastly increased their holdings of liquid assets which fell sharply in late 2008. Admittedly, in recent quarters, liquid assets have started to moderate again (Chart 1).

  • Furthermore, the FX reserves of the government are roughly double their pre-crisis levels, even if still modest by some metrics (Box 4) and due in part to outstanding liabilities to the IMF (Chart 2)

However, Hungary remains exposed to several underlying vulnerabilities:

  • Despite the ban on new lending in FX, Hungary still faces large currency mismatch on stocks. Given the relatively long maturity of FX loans, this is unlikely to change quickly (Chart 3).

  • While there has been some reduction in external liabilities in recent quarters, banks’ foreign borrowing remains large and the share that is short term has been rising (Chart 4).

  • While lower than during the crisis, banks’ dependence on the FX swap market remains somewhat above pre-crisis levels. Also, the improvement in the swaps’ maturity structure has stalled (Chart 5).

  • Amid the recent increase in appetite for Hungary risk, non-resident holdings of government paper (MNB bills and Treasury Bonds) are now back to pre-crisis levels (Chart 6).

Box Figure.
Box Figure.

Hungary: Crisis Vulnerabilities, Then and Now

Citation: IMF Staff Country Reports 2011, 137; 10.5089/9781455279555.002.A001

Sources: MNB; and IMF staff estimates.

B. Policy Responses

9. The authorities have revised down their general government surplus target to 2 percent of GDP to accommodate a number of one-off expenses and weaker than initially expected revenue. (Text Table) This year’s budget continues to rely heavily on one-off asset transfers from the recently dissolved second pension pillar (10 percent of GDP), as well as transitory levies on the financial, telecommunication, energy and retail sectors. With the resulting headline fiscal balance in surplus (in ESA terms), the authorities are undertaking a number of one-time expenditures, including (i) the assumption of the entire debt of public transport companies MAV and BKV, (ii) the cancellation of some previously contracted private-public partnership projects, and (iii) compensation for past voluntary contributions and real returns to the 97 percent of contributors who switched back to the first pension pillar. Moreover, after the poor budget performance in recent months, the authorities have introduced across-the-board expenditure cuts of 0.9 percent of GDP to help them meet the revised budget. Once accounting for the business cycle and excluding the various one-off items, staff estimates that the revised fiscal target implies a 4½ percent of GDP structural deficit in 2011, suggesting a further ¼ percent of GDP structural deterioration compared to 2010.

General Governmnent Balances in 2011

(Percent of GDP, unless otherwise indicated)

article image
Sources: Hungarian authorities; and IMF staff estimates.

In percent of potential GDP.

10. The recently announced structural reform program, the Szell Kalman Plan, aims to restore fiscal sustainability and investor confidence. The package, which relies primarily on expenditure measures, targets 1.8 percent of GDP fiscal consolidation in 2012 and an additional 1 percent of GDP in 2013 (Text Table next page). The plan spells out specific measures in some areas while providing a timetable for releasing further details later in other areas. The spending cuts focus on social benefits, eligibility for early retirement and disability pensions, health care (especially subsidized pharmaceuticals), education, and public administration (local governments, see Box 2). On the revenue side, the plan reverses previous intentions to halve the financial sector levy in 2012 and reduce the standard Corporate Income Tax (CIT) rate from 19 to 10 percent in 2013; also, a road toll system will be introduced. To bring the headline 2012 deficit below 3 percent of GDP as required under the EU’s excessive deficit procedure, the authorities are also planning to make the above-mentioned across-the-board expenditure cuts permanent, increase excises and fees on environmentally harmful goods, and substantially reduce the basic PIT allowance.

Measures of the Szell Kalman Plan

(Forint billion, unless otherwise indicated)

article image
Sources: Hungarian authorities; and IMF staff estimates.

Local Government Finances

Local government finances are under stress. Deficits are most acute in poor districts due to over-reliance on income-based revenue. This regional inequality is only partially compensated by central government transfers. Fiscal deterioration is compounded during election years amid substantial political pressure for higher expenditures. As a result, local government debt has steadily risen, reaching 5 percent of GDP at end-2010.

The Szell Kalman plan seeks to address this slippage. First, the authorities hope to increase efficiency by consolidating the provision of administrative serves. And second, the plan tightens rules for local government debt issuance by preventing debt financing of current deficits and requiring central government approval for debt-financing of capital projects. However, the specifics of the plan have yet to be decided and the authorities have requested Fund technical assistance.

uA01fig02
Sources: Hungarian authorities; and IMF staff estimates.

11. The announced consolidation efforts will occur in the context of important changes to fiscal institutions. First, the recently approved new constitution explicitly sets a public debt ceiling of 50 percent of GDP, although the exact transitional rules for the reduction from the present 80 percent still need to be spelled out. Second, a new Fiscal Council (replacing the one dissolved in December 2010) will express an opinion each year on the soundness the government’s draft budget estimates. Finally, local governments will be required to obtain Central Government approval of all debt issuance related to the financing of capital projects, and will be prohibited from issuing debt to finance current spending.

12. On monetary policy, the MNB ended a 75-bps tightening cycle in January, leaving the key policy rate at 6 percent. The authorities began increasing the monetary policy rate in November amid forecasted inflation above the target for the entire horizon period as well as upward pressure on the risk premium. Medium-term inflation pressures subsequently subsided as the pass-through from supply shocks turned out to be lower than forecast, allowing core inflation to remain stable. The recent decline in risk premia has also further reduced the pressure for further monetary tightening.

13. After consultation with the banking community, the government is nearing completion on a set of measures to address strains related to mortgage portfolios. (Box 3). The aim of the proposal is to improve the functioning of the mortgage market, contain outstanding risks associated with FX lending, and limit social hardship. To do so, the authorities plan to reverse some recent policies (moratorium on evictions and the de facto ban on FX-denominated mortgage lending), directly support the purchase of foreclosed properties (subsidies to private sector buyers and outright government purchases by a national asset management fund), and limit the impact the impact of currency volatility on bank and household balance sheets (temporary exchange rate fixing for mortgage servicing).

Measures in the Scheme to Support Mortgage Debtors and an Efficient Functioning of the Mortgage Market

Housing related loans stand at 25 percent of GDP, with the non-performing portion currently only 1-2 percent of GDP. If, however, there were a sharp fall in prices (e.g. when foreclosures resume) or the exchange rate (3/4 of these loans are in FX), the stress to the financial sector and the economy more broadly could be considerable. To address such potential strains, the government is developing a set of measures in consultation with the banking community. Many important details are still not known. General concerns about these proposals as conveyed to the mission are discussed in ¶ 22.

  • Elimination of the temporary ban on foreclosures and evictions due to mortgage default. The moratorium has been in place since 2010 to limit the social impact of the economic crisis on home owners. However, it blocks banks’ access to mortgage collateral, and has therefore likely contributed to an erosion of credit discipline. It also prevents banks from effectively working out the impaired portions of their portfolios. Following the end of the moratorium, quarterly quota on the amount and geographical distribution of properties banks can foreclose will be set to limit the impact on the real estate market.

  • Elimination of the de facto ban on euro (and possibly CHF) lending4, with a view to reduce mortgage borrowing costs. Presumably, the prudential regulations existing prior to the ban’s imposition in mid-2010 would become effective again; these prescribe more conservative loan-to-value and loan-to-income ratios for euro loans relative to forint loans.

  • Temporary fixing of the exchange rate for mortgage debt servicing. For mortgage debtors, the exchange rate of the Swiss franc (and possibly the euro) against the forint will be fixed at a level to be determined. Payments above the fixed amount will be accumulated in a fund for a period of 3–4 years. At the end of the fund’s lifetime, its outstanding balance will be distributed over the loan’s remaining maturity and will be guaranteed by the government against a fee. Depending on the interest rate used, the scheme may amount to a NPV-neutral loan rephasing, but includes fiscal risks in case the CHF remains appreciated and households default after the end of the fixing period. Calculations by the MfNE suggest that these risks are manageable.

  • An interest rate subsidy for loans to purchase foreclosed property to support demand and limit the decline in real estate prices. The subsidy will only be available for loans denominated in forint, with a maximum amount of 350 bps that will be phased out over time. To become eligible for the subsidy, the bank foreclosing the property needs to commit to paying the rent of the evicted pre-owner for a period of 18 months, and wave claims on the pre-owner’s assets beyond the foreclosed property. Total budgeted costs amount to 0.1 percent of GDP.

  • A national asset management fund, administered by local authorities but supported through the central government budget, that will purchase foreclosed properties and rent these back to the previous owner. The fund is limited to 5000 properties, with budgeted costs of less than 0.1 percent of GDP.

Elements of means-testing will likely apply to most schemes but have not yet been determined. Moreover, the schemes will be verified against state-aid provision of the EU.

III. Report on the Discussions

A. Macroeconomic Outlook and Risks

14. The combination of serious headwinds to domestic demand and ongoing positive outlook for exports imply that the recovery will remain modest and uneven. Staff revised downward its outlook for real growth to 2 ½ percent for both this and next year, about ½ percent less than the authorities’ baseline projection. Remaining differences of view relate to the strength of German exports, the evolution of precautionary savings, the short-term contractionary effect of the Szell Kalman plan, and prospects for investment growth. Staff and the authorities agreed that, assuming full implementation of planned structural reforms, potential growth could rise to 2½ to 3 percent in the medium term. The authorities’ medium-term projections for the external current account in the Convergence Program are, however, much more optimistic than staff’s, suggesting surpluses through 2015.

15. Staff underscored ongoing risks amid Hungary’s challenging external amortization schedule. In early 2011, Hungary benefitted from rising investor demand which both helped cover public sector financing needs and reduce inflationary pressures. However, staff highlighted that the currently benign scenario was highly exposed to both domestic policy missteps (such as delays in implementing the Szell Kalman plan) as well as exogenous events (such as a drying up of capital inflows or possible spillovers from difficulties in the European financial system). Either development could put upward pressure on risk spreads which would further depress domestic demand (via the impact of a weaker exchange rate on household balance sheets) and complicate meeting external amortizations (via lower rollover rates). The authorities agreed that these were risks but emphasized that they were mitigated by their determination to follow through with the planned fiscal adjustment.

B. Policies

Structural Reform Package and Fiscal Policy

16. Staff welcomed the Szell Kalman Plan as a step towards restoring debt sustainability. Key elements of the plan—labor market and social benefit reform, deferral of permanent CIT cuts—and the publication of a timeline for legislative action are consistent with earlier Fund advice (including during the recent Article IV consultation). Taken at face value, the plan’s intended savings and attending structural reforms would put public debt on a clear downward path and improve medium term growth prospects (see Text figure 2). The DSA incorporating the envisioned savings still suggests ongoing sensitivity to growth shocks (see Appendix I). Remaining differences between staffs and the authorities’ projected baseline debt and deficit paths (especially in 2012) are explained by staffs more cautious macroeconomic framework and different assumptions about local government’s ability to adjust spending. Some uncertainty remains about the near-term evolution of the debt stock as the authorities have not yet decided how much of the pension asset transfers will be used for immediate debt reduction.5

uA01fig03
1/ The measures include the Szell Kalman Plan and the additional fiscal consolidation measures announced for 2011.Sources: Hungarian authorities; and IMF staff estimates.

17. The authorities agreed with some, but not all, implementation risks identified by staff. Far-reaching social benefit cuts and revenue measures are reasonably well specified, suggesting a relatively high likelihood that they will be put in place quickly. Health and pension reforms, however, still lack detail and their outcome remains subject to the renegotiation of existing contracts (including with pharmaceutical companies) and to individual reassessments of eligibility—challenges acknowledged by the authorities. They also agreed that implementation risks loom large with respect to local government reform (see Box 2), which is why they envisaged substantial savings only from 2013 onward.

18. Regarding prospects to address the perennial deficits of state-owned transport companies, the authorities were more optimistic than staff. They argued that conditioning the assumption of MAV’s debt on a comprehensive upfront restructuring plan, as suggested by staff, may shift this expenditure into 2012 and complicate meeting that year’s deficit target agreed with the EU. While the authorities’ public transport measures focus mainly on generating interest savings following the transfer of their debt to the state, staff urged to address underlying vulnerabilities such as overstaffing and other excessive operational costs.

19. Staff also questioned the quality of some measures, including the plan’s impact on the most vulnerable. Staff argued that means-testing of social benefits would be preferable to the planned across-the-board cuts, especially in view of the highly regressive PIT reforms passed last year. The authorities stressed that the social benefit cuts, along with a new public works program, were primarily intended to move workers at all income levels into employment. They did express interest in fine-tuning eligibility criteria for some benefits such as child allowances, for which they requested Fund technical assistance. The authorities saw less urgency than staff in addressing overstaffing in public administration (a key area of expenditure rationalization identified by last year’s TA mission) as well as state-owned enterprises.

20. Further efforts are needed to secure long-term fiscal sustainability. Specifically, pension sustainability needs to be reassessed following the de facto nationalization of the second pension pillar. In this context, staff warned the authorities against taking comfort in the improvement of the first pillar’s short-term cash position and reiterated concerns about the use of some returned pension assets for current spending. The authorities pointed to the recent switch to inflation indexation, which on the margin will improve long-term sustainability. Furthermore, their Convergence Program (published after the mission) envisages continued fiscal adjustment beyond the Szell Kalman plan’s measures implemented in 2012–13, aiming at a headline general government deficit of 1½ of GDP and public debt below 65 percent of GDP in 2015.

21. Staff also expressed concern about several aspects of the new fiscal framework. While the new Fiscal Council has formal veto power over the budget and could in extremis dissolve parliament, staff thought that in practice it was unlikely to resort to such drastic actions. Moreover, the Council’s mandate is more narrow than that of its predecessor: it only allows a once per year assessment of a given draft budget’s feasibility rather than examining medium-term implications and educating the public on policy initiatives on an ongoing basis. Regarding the new constitutional debt limit, staff suggested to design implementation rules that allow for automatic stabilizers and avoid the pro-cyclical stance imposed by a binding debt ceiling. More generally, staff warned that the frequent changes to the fiscal framework may undermine confidence and policy stability. The authorities emphasized the latest changes were here to last, as they were anchored in the new constitution.

Financial Sector Policies

22. Staff welcomed the government’s work with banks on normalizing conditions in the mortgage market, noting however that measures currently under consideration still lack important detail. The authorities acknowledged that the bank levy, the ban on foreign-exchange lending, and the foreclosure moratorium may be weighing on credit. Furthermore, staff agreed that a proposal that combines elimination of the bans on FX lending and foreclosures with temporary relief for borrowers may help the financial sector play a stronger role in the recovery going forward. That said, staff noted that support measures need to be well-targeted to minimize moral hazard and contain fiscal risks. For example, the exchange rate used under the fixing scheme (see Box 3) should be set at distressed levels and all subsidy schemes should include elements of means-testing. Such key parameters should be clarified as soon as possible.

23. Regarding Hungary’s outsized bank levy, staff argued that its recent extension until 2013 and uncertain plans thereafter were undermining financial sector stability. Banking groups had started shifting funding and lending activity from Hungary to other countries in the region. The authorities reiterated their intention to eventually replace the levy with a smaller tax in line with emerging EU practice. Staff pointed out that an EU-wide standard was unlikely to materialize soon and suggested consideration of a financial activity tax if the purpose remained general revenue collection.

24. The authorities noted a recent decline in the total size and average maturity of banks’ external funding. In recent months, banks have begun to reduce liquidity ratios from their elevated post-crisis levels. Though such normalization can be appropriate, the counterpart of the sale of liquid assets has largely been a repayment of long-term foreign liabilities, including to parent banks. This leaves Hungary’s banks more exposed, at the margin, to shorter-term FX funding, both on balance sheet and in the FX swap market. Meanwhile, amid this shortening in the average maturity of FX funding, banks’ substantial portfolio of longer term FX assets remains broadly unchanged given the average duration of mortgage loans in Swiss francs. The authorities thought that banks may be emphasizing profit at the expense of prudential considerations, which was particularly risky in light of ongoing tension in the European financial sector. Staff noted that parent banks had been a key source of additional financing during the crisis but broadly agreed with the authorities’ assessment that recent developments on the whole increased liquidity risks. Furthermore, staff thought that the authorities’ focus on macroprudential measures to address risks related to currency and maturity mismatch (along the lines of the Basel III stable funding ratio and liquidity coverage ratio) was appropriate, but felt that the broader issue also supported the argument for higher foreign exchange reserves going forward.

25. Staff observed that advances made in on-site inspections had been preserved, but reiterated its earlier concerns that the framework for financial stability had been weakened. On-site inspections continue at a similar frequency and intensity for systemically important banks as in the past two years. Moreover, the long-sought inspection of foreign subsidiaries of Hungarian banks in non-EU countries through an independent external auditor is now ongoing. The tri-partite financial stability council, consisting of the Hungarian Financial Supervisory Authority (HFSA), the MNB, and the Ministry of the National Economy is continuing, but its ability to initiate financial legislation or regulation on a “comply or explain” basis has been removed. Cooperation with banks’ home country supervisors is also ongoing.

Monetary Policy and Reserve Management

26. Staff and the MNB agreed that putting rates on hold is adequate at this juncture. The risks from commodity prices were counterbalanced by the weak economy and improved risk premium. Looking forward, staff noted that potential monetary tightening elsewhere in Europe could complicate monetary policy if it triggered currency weakening before domestic demand had recovered. The authorities thought that such a risk was contained as they expected any tightening by the ECB to be slow in pace and moderate in degree. More generally, monetary policy remains constrained by the need to avoid disorderly exchange rate depreciations in view of pervasive FX exposures particularly on household balance sheets.

27. With current reserve coverage broadly adequate but modest by some measures (see Box 4), staff thought that going forward some additional accumulation would be useful. Higher reserves would provide a helpful safety cushion given forthcoming external financing requirements for both the banking system and the public sector. In particular, the government’s challenging 2012–14 amortization schedule—including its capacity to meet obligations to the Fund6—requires roll over rates for external market-held debt well above 100 percent. Furthermore, a reserves-to-short-term-debt ratio as low as 80 percent projected for 2011 (and only slightly increasing thereafter) compares unfavorably with neighboring countries and may have negative signaling effect in the markets. MNB staff pointed out that the short-term debt metric overstates the risks because a considerable part of such debt related to more stable parent bank funding of subsidiaries and intercompany loans. Going forward, MNB projections suggest that reserve coverage would still be within the target range suggested by its new framework for assessing reserve adequacy7, although this assumes a further pick-up up of EU transfers and sovereign debt placements.

28. The authorities also saw drawbacks to staff’s suggested means of increasing reserves. Several options were discussed:

  • Selling all foreign assets from the pension assets transfer (rather than 60 percent, as presently planned) and depositing receipts at the MNB. The authorities pointed out that some of these assets are relatively illiquid and thus difficult to sell quickly.

  • Small, regular and preannounced FX purchases in the foreign exchange markets (similar, for example, to Turkey). The MNB was concerned that such an announcement would be difficult to communicate in a way that did not affect the exchange rate.

  • Issuance of long-term FX-denominated sovereign debt in excess of current financing plans. The authorities said that additional external debt accumulation, even in the short term, would run counter to their stated goal to reduce debt.

More generally, staff stressed that a strong policy record would help improve reserve adequacy, by increasing private sector inflows and also by facilitating Hungary’s access to international back-up facilities (e.g., precautionary Fund and EU arrangements or central bank swap lines). While the authorities agreed that a sound policy mix was critical, they said that such foreign support lines were not under consideration.

Alternative Metrics of Reserve Coverage

The literature and policy makers’ experience provides a set of metrics for reserve adequacy. Traditional metrics include the extent to which the stock of reserves covers: (i) the stock of short-term debt at remaining maturity (to cover redemption obligations in the event of a drop in investors’ appetite for rolling over the maturing debt); (ii) three months of imports (to cover import needs in the event of a drop in sources of foreign exchange); and (iii) 20 percent of broad money, to cover against significant capital (deposit) flight.

A new metric, recently elaborated in a Board paper (see Assessing Reserve Adequacy), looks at the level of reserves necessary to smooth the impact of large foreign exchange outflows as witnessed in severely affected crisis countries. Furthermore, the metric builds on the approach used for bank capital by “risk-weighting” different types of potential outflows. For countries with flexible exchange rate, in particular, it measures the level of reserves that would be able to cover a 30 percent reduction in short-term debt, a 10 percent reduction in other liabilities, a capital flight amounting to 5 percent of broad money, and a drop of 5 percent in exports.

Based on 2010 stocks, Hungary’s reserves are at adequate levels by most metrics, but fall significantly short (75 percent or nearly €11 billion) of short-term debt at remaining maturity (see charts below). By this metric, Hungary also falls below its peers in Eastern Europe. Whether achieving a-100 percent coverage is necessary, is open for debate as it depends on the risk of a severe sudden stop in capital flows and the impact on current investors’ confidence.

uA01fig04

International reserves and metrics /1

(Billions of euros)

Citation: IMF Staff Country Reports 2011, 137; 10.5089/9781455279555.002.A001

1/ The bar shows current and projected reserves in billions of Euros. The other symbols show the quantity of reserves needed to be adequate under different metrics including 3 months of imports, 100% of ST debt, and 20% of M2. The series “new metric” is a weighted combination of these thresholds. Short-term debt includes staffs estimate of intercompany loans falling due within one year.

IV. Staff Appraisal

29. Weighed down by long-standing vulnerabilities, Hungary is slowly rebounding from the 2008–09 crisis. Ongoing doubts about the policy environment as well as fundamental weakness in credit, wages, and employment have been holding back the resumption of investment and consumption. Meanwhile, exports have performed well on the back of a supportive external environment, particularly in Germany. To make the economic recovery self-sustaining, however, Hungary needs to consolidate its public finances and remove structural impediments to growth.

30. The authorities’ recently announced Szell Kalman structural reform plan represents an effort to tackle these issues. The size and scope of the envisaged multi-year fiscal consolidation are broadly appropriate, marking a welcome departure from the ad hoc and distortionary policy steps taken in 2010. In particular, the plan rightly focuses on reducing expenditures by rationalizing public services and removing obstacles to an increase in Hungary’s low labor participation rates. Taken at face value, this plan will put public debt on a downward path, reduce risk premia, and eventually lift potential growth.

31. However, the reform plan should be modified in a number of important areas. More urgency should be placed on civil service reform, with concrete steps to reduce overstaffing at all levels of government. Means-testing of social benefits rather than cross-the-board cuts would be more durable and avoid placing a disproportionate burden on the most vulnerable. The restructuring of public transport companies could be more ambitious. Finally, special levies on specific sectors introduced last year should be eliminated as soon as possible, as they undermine the business climate. These steps would improve the plan’s sustainability and potential to boost potential growth.

32. Substantial implementation risks call for early and decisive action. Fiscal slippages in 2010 and 2011 to date highlight the difficulty of translating policy intentions into results, particularly in the context of a still weak economy. In this context, the surplus in this year’s budget (which is entirely due to the one-off revenue effect of the de-facto nationalization of the second pension pillar) and the current benign market environment must not lead to complacency, especially in light of the electoral timetable and a challenging public debt amortization schedule after 2012. To reduce implementation risks, the plans’ timetable for spelling out specific policies should be adhered to strictly. Some measures, such as modifications to social benefit schemes, could already be put in place in 2011, with the additional advantage of spreading out the adjustment. Finally, assuming the debt of transport companies by the state should be delayed until a credible up-front restructuring plan is developed.

33. Some recent changes to the fiscal framework could usefully be revisited. The new Fiscal Council’s mandate is narrower than that of its recently abolished predecessor, limiting its ability to provide effective governance. The new constitutional debt limit provides a welcome signal of the authorities’ determination to restore fiscal sustainability, but should be supplemented with carefully designed rules governing the transition from the present level and avoiding procyclical fiscal policies.

34. With respect to financial sector issues, recent focus on addressing stress in real estate portfolios is welcome, but broader risks in the sector also warrant attention. The measures now under discussion, especially the elimination of the FX lending and mortgage foreclosure ban, may help resume credit growth—although a final assessment will depend on crucial parameters that are still unknown. Support schemes for distressed mortgage holders are welcome but should be transparent and means-tested so as to minimize fiscal cost and moral hazard. Banks’ large open FX position and their continued dependence on external funding call for increased vigilance, especially in view of ongoing tensions in the European financial sector. In this context, the authorities would be well advised to quickly eliminate the outsized bank levy as it is encouraging parent banks to shift funding and lending activity away from Hungary.

35. The current monetary policy stance appears appropriate. Still low core inflation and reduced risk premia allow keeping policy rates on hold for now. In light of a volatile global environment, the MNB should continue to monitor price and financial market developments closely.

36. In view of high rollover risks for the sovereign and the banking system, some increase in reserve coverage would provide additional insurance. Additional buffers are particularly important in view of ongoing tensions in the European financial system and large external amortizations falling due in 2012–14, including to IMF an EU. Further reserve accumulation could be achieved for example by diverting a larger share of foreign assets from the recently dissolved second pension pillar to the MNB; instituting small, regular and preannounced FX purchases; and issuing additional FX-denominated debt if market conditions remain favorable. Securing international back-up facilities, conditional on strong policy implementation, could also help.

Table 1.

Hungary: Main Economic Indicators, 2007–12

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Sources: Hungarian authorities; IMF, International Financial Statistics; Bloomberg; and IMF staff estimates.

Contribution to growth. Includes change in inventories.

Calculated using previous year’s prices

Excludes change in inventories.

Consists of the central government budget, social security funds, extrabudgetary funds, and local governments. It includes the impact of the government’s fiscal consolidation package announced in February 2011, as estimated by the authorities, and the transfer of Pillar two pension assets to the state.

Excluding Special Purpose Entities. Including inter-company loans, and nonresident holdings of forint-denominated assets.

Table 2.

Hungary: Central Bank Survey, 2006–12

(Forint billions)

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Sources: Magyar Nemzeti Bank; and IMF staff estimates.
Table 3.

Hungary: Monetary Survey, 2006–11

(Forint billions)

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Sources: Magyar Nemzeti Bank; and IMF staff estimates.

Adjusted for changes in exchange rate

Only credit to households and firms

Table 4.

Hungary: Balance of Payments, 2005–16

(Euro millions)

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Sources: Hungarian authorities; and IMF staff estimates.

In 2011 includes liquidation of foreign assets in 2nd pillar pension funds projected at euro 2.5 bn.

Table 5:

Hungary. Balance of Payments, 2005–16

(Percent of GDP)

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Sources: Hungarian authorities; and staff projections.

In 2011 includes liquidation of foreign assets in 2nd pillar pension funds projected at euro 2.5 bn.

Table 6.

Hungary: External Financing Needs, 2009–16

(Euros millions)

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Sources: Hungarian authorities; and IMF staff estimates.

Excludes EU and IMF loans.

Table 7.

Hungary: Indicators of External Vulnerability, 2006–11

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Source: Hungarian authorities; and IMF staff estimates.

Loans to households and non-financial corporations adjusted for movements in the exchange rate.

Non-performing loans are defined as corporate, household, interbank, foreign and other loans that are past due for more than 90 days.

Special Purpose Entities are defined as resident corporations of non-resident owners, which perform a passive, financial intermediary function between the non-resident partners. SPEs have a marginal impact on the domestic economy, and their transactions have negligible net impact on the balance of payments (an enterprise that has a non-negligible net impact on the balance of payments is removed from the list of SPEs). Foreign assets and liabilities of SPEs are largely matched, and loans are considered as FDI in accordance with international statistical standards. Data for SPEs are not available prior to 2006.

Includes an estimate of intercompany loans falling due in the short-term.